Financial markets are fickle monsters. Whichever way the herd moves the market will go the other direction. I first described this phenomenon in the post How Subprime Lending Created the Housing Bubble, and I extrapolated on that idea in What is Past is Prologue. If you were not a reader of the site in early 2007, I suggest you click on those links and check them out.
During the bubble rally, prices were pushed up the herd mentality. As prices rose, more and more people were convinced prices would continue to rise, so the pool of buyers swelled. Credit standards dropped to qualify more buyers, and the party went on and on. When credit standards were basically eliminated in 2004 and downpayments were eliminated, the buyer pool saw one last burst of activity until everyone that could buy, did buy. The herd had all "gone long" on real estate. The problem came when the pool of available buyers was exhausted and there was nobody left to push prices any higher. Once the herd had all purchased, the only thing they were able to do was sell. When the entire herd became sellers and there were no more buyers available, sales volumes dropped off, inventories increased and prices began to fall.
The behavior of the herd can be illustrated through the behavior of the individual participants. Today's featured property was purchased by a realtor in late 2003 for no money down. He pulled out a bunch of equity, and now he has listed the property at a price that will pay off the debt and get him out of the transaction. There are hundreds if not thousands of people out there just like today's owner trying to get out of their properties. The collective term for this group is called "overhead supply." It is overhead supply that will prevent any appreciation until the market clears them out. The way markets normally do this is through a process known as "capitulatory selling." People resign to their fate and sell at a loss. Some will do it willingly, and some will do it through foreclosure, but the market will clear them all out eventually. The way it looks right now, the process of capitulatory selling is increasing, and it will likely continue to increase through 2009.
The United States Department of Labor Bureau of Labor Statistics measures the Rent of primary residence (rent) and Owners' equivalent rent of primary residence (rental equivalence). They make this distinction because a house has both a consumptive purpose and an investment purpose. The consumptive value is measured by rent or rental equivalence. There is legitimate financial reason pay more than the rental equivalence price. The normal rate of house appreciation – not the unsustainable kind witnessed during the Great Housing Bubble – can provide a return on investment. The source of this added value is the leverage of mortgage financing and the hedge against inflation obtained through a fixed-rate mortgage. The investment premium, which is about 10%, is less than most people think.
The rental equivalence value is the fundamental value of real estate, and it is also its consumptive value. This value can be easily measured as demonstrated in the post Rent Versus Own. There is an independent investment value that can also be measured and added to the consumptive value to arrive at the maximum resale value of the property. Investment value is derived from two sources: the increase in property value through appreciation and the long-term savings over renting caused by inflation. These two components are measured separately to demonstrate how they function and how much each of them is worth.
Since the return on investment generated from residential real estate occurs in the future, a discounted cashflow analysis is required to determine the net present value of the future returns. Calculating net present value sounds complex, and manually going through the calculations is quite cumbersome, but electronic spreadsheets make this an easy task. The concept is simple: how much money would an investor put money in an investment today if they knew the rate of growth and the cash value to be realized in the future. For instance, if an investor put $100 in a bank earning 5% interest, they would have $105 at the end of the year. Net present value looks at the situation in reverse. If the investor knew they would receive $105 at the end of the year and the market interest rate was 5%, they would be willing to pay $100 for it today. Similarly, the investment value of residential real estate is the value today of an amount of money to be received in the future either through sale or savings on rent.
Discount Rates
The investment value of a property can only be measured against other investment opportunities available to an investor. If an investor can earn 4.5% in government treasuries, they will demand a higher return to invest in an asset as volatile and as illiquid as residential real estate. The rate of return an investor demands is called a “discount rate.” The discount rate is different for each investor as each will have different tolerances for risk. During the Great Housing Bubble discount rates on most asset classes were at historic lows due to excess liquidity in capital markets. The discount rate used in the analysis is the variable with the greatest impact on the investment value. Because of the risks of residential real estate, a strong argument can be made that a low discount rate is unwarranted and investors would typically demand higher rates of return for assuming the inherent risks. A low discount rate exaggerates the investment premium and makes an investment appear more valuable, and a high discount rate underestimates the investment premium and makes an investment appear less valuable.
The US Department of the Treasury sells a product called Treasury Inflation-Protected Securities (TIPS.) The principal of a TIPS increases with inflation, and it pays a semi-annual interest payment providing a return on the investment. When a TIPS matures, they buyer paid the adjusted principal or original principal, whichever is greater. This is a risk-free investment guaranteed to grow with the rate of inflation. The rate of interest is very low, but since the principal grows with inflation, it provides a return just over the rate of inflation. Houses have historically appreciated at just over the rate of inflation as well; therefore a risk-free investment in TIPS provides a similar rate of asset appreciation as residential real estate (approximately 4.5%.) Despite their similarities, TIPS are a much more desirable investment because the value is not very volatile, and TIPS are much easier and less expensive to buy and sell. Residential real estate values are notoriously volatile, particularly in coastal regions. Houses have high transaction costs, and they can be very difficult to sell in a bear market. It is not appropriate to use a 4.5% rate similar to the yield on TIPS or the rate of appreciation of residential real estate as the discount rate in a value analysis.
Another convenient discount rate to use when assessing the value of residential real estate is the interest rate on the loan used to acquire the property. Borrowed money costs money in the form of interest payments. A homebuyer can pay down the loan on the property and earn a return on that money equal to the interest on the loan as money not spent. Eliminating interest expense provides a return on investment equal to the interest rate. Interest rates during the Great Housing Bubble on 30-year fixed-rate mortgages dropped below 6%. An argument can be made that 6% is an appropriate discount rate; however, 6% interest rates are near historic lows, and interest rates are likely to be higher in the future. Interest rates stabilized in the mid 80s after the spike of the early 80s to quell inflation. The average contract mortgage interest rate from 1986 to 2007 was 8.0%. If a discount rate matching the loan interest rate is used in a value analysis, it is more appropriate to use 8% than 6%.
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Investors in residential real estate, those who invest in rental property to obtain cashflow, typically ignore any resale value appreciation. These investors want to receive cash from rental in excess of the costs of ownership to provide a return on their investment. Despite their different emphasis for achieving a return, the discount rates these investors use may be the most appropriate because it is for the same asset class. Cashflow investors in rental real estate have already discounted for the risks of price volatility and illiquidity. Historically, investors in cashflow producing real estate have demanded returns of near 12%. During the Great Housing bubble, these rates declined to as low as 6% for class “A” apartments in certain California markets. It is likely that discount rates will rise back to their historic norms in the aftermath of the bubble. If a discount rate is used matching that of cashflow investors in residential real estate, a rate of 12% should be used.
Once money is sunk into residential real estate, it can only be extracted through borrowing – which has its own costs – or sale. Money put into residential real estate is money taken away from a competing investment. When a buyer is facing a rent versus own decision, they may chose to rent and put their downpayment and investment premium into a completely different asset class with even higher returns. This money could go into high yield bonds, market index funds or mutual funds, commodities, or any of a variety of high-risk, high-return investment vehicles. An argument can be made that the discount rate should approximate the long-term return on high yield alternative investments, perhaps as high as 15% or 18%. Although an individual investor may forego these investment opportunities to purchase residential real estate, it is not appropriate to use discount rates this high because many of these investments are riskier and more volatile than residential real estate.
The discount rate is the most important variable in evaluating the investment value of residential real estate. Arguments can be made for rates as low as 4.5% and as high as 18%. Low discount rates translate to high values, and high rates make for low values. The extremes of this range are not appropriate for use because they represent alternatives investments with different risk parameters that are not comparable to residential real estate. The most appropriate discount rates are between 8% and 12% because these represent either credit costs (interest rates) or the rate used by professional real estate investors. The examples in this section will use these two rates to illustrate the range of values rational investors in residential real estate would use to value an investment premium.
Appreciation and Transaction Fees
The portion of investment value caused by appreciation can only be evaluated by an accurate estimate of appreciation during the ownership period. The general public grossly overestimates the rate of home price appreciation . Historically, houses have appreciated at a rate 0.7% over the general level of inflation. From 1983 to 1998, a period of low inflation and declining mortgage interest rates before the bubble, the rate of house price appreciation was 4.5% nationally which was 1.4% over the rate of inflation. Appreciation rates are tied to income and rents because this is the fundamental value of residential real estate.
Profiting from house price appreciation requires getting more money from the sale of a property than was originally paid for it. Buying and selling residential real estate incurs significant transaction costs that are not reflected in the price. It is quite common for properties to sell for more than their purchase price and still be a loss for the seller. When people purchase residential real estate they pay numerous closing costs including title insurance, recording fees, document stamps and taxes, mortgage application fees, survey fees, inspection fees, appraisal fees, et cetera. These fees often total between 2% and 4% of the purchase price not including any prepaid interest points on the mortgage. When people go to sell residential real estate they generally go to real estate broker who will charge them a 6% commission. There is an increasing popularity in discount brokers, but the National Association of Realtors has done a remarkable job of keeping brokerage commissions at 6% despite market pressures to lower them. These transaction costs are part of every residential real estate transaction, and they take a substantial portion of the profit on properties with short holding periods, and if the holding period is not long enough, transaction fees create losses.
The negotiating abilities of buyers and sellers and the overall market environment greatly impact the profits from real estate. Sellers almost universally believe their properties are worth more than the market will bear. People become emotionally attached to their houses, and because it is very valuable to them, they assume it is just as valuable to a person who is not attached to the property. Sellers always hope to find the buyer who will appreciate their home as much as they do and thereby pay top dollar for it. All homeowners have unrealistic expectations of appreciation. The combination of emotional attachment and unrealistic appreciation expectations cause sellers to believe their house is more valuable than it is, and when it comes time to sell, they price it accordingly. Sellers usually are forced to discount a property from their perceived value in order to sell it. In raging bull markets, sellers can sometimes get more than their asking price, and in bear markets, they may have to discount the property significantly in order to sell it. Bear markets are the most difficult because sellers have difficulty lowering their prices, particularly if they must sell at a loss. Sometimes the difficulty in lowering price is caused the amount of debt on the property, and sometimes it is caused by seller’s emotional issues. No matter the cause, the inhibition to lowering price often results in a failure to sell the property. Since this process of discounting to sell is already reflected in the historic appreciation rate, no further adjustment is required to account for it.
The key variables for the calculation of the portion of investment value due to appreciation are the rate of appreciation, the investment discount rate and the transaction fees. In the calculation that follows the rate of appreciation is 4.5%, the discount rate is 8%, and transaction costs are 2% for the purchase and 6% for the sale. There is a 20% downpayment, and the loan is assumed to be an interest only to avoid the complications of a decreasing loan balance in the calculation and isolate the appreciation premium.
Appreciation Premium and Holding Period using an 8% Discount Rate
Due to the high transaction costs, the property does not reach breakeven until two full years of ownership. In a discounted cashflow basis, the property does not break even until after 4 full years of ownership. It is these high transaction costs that compel many with short-term housing needs to rent rather than own. Assuming an 8% discount rate and a term of ownership of 10 years or more, there is a premium for ownership of approximately 10%. This means the owner could pay up to 10% over the rental equivalent value and still obtain an 8% return on their money – assuming they can sell it for 10% over rental equivalent as well.
There is a tendency in the general public to assume the leverage of real estate provides excessive returns. It does magnify the appreciation, but since the historic and sustainable rate of appreciation is a low 4.5%, the leverage is applied to a small growth rate resulting in less than stellar investment returns. In the previous examples, if the downpayment is lowered to 10%, the investment premium at an 8% discount rate rises to 15%, and with a 12% discount rate, there are some ownership periods justifying a premium. If the downpayment is dropped to 1%, the ownership premium rises as high at 20%. At its most extreme with 100% financing, any positive return becomes infinite because the investor has no cash investment. Ownership premiums of 10% to 20% sound large, but in coastal markets during the Great Housing Bubble, buyers were paying ownership premiums in excess of 100%. There is no rational justification for these price premiums.
Appreciation Premium and Holding Period using a 12% Discount Rate
Larger discount rates eliminate the appreciation premium on residential real estate. The money tied up in a 20% downpayment on residential real estate appreciating at 4.5% provides a rate of return less than 12%; therefore when the gains from appreciation are discounted at 12%, the net present value never goes positive. When investors demand returns equal to or greater than 12%, there is no investment value from appreciation in residential real estate.
Inflation Premium
Residential housing does have a cash-saving value, if financed with a fixed rate mortgage. Over time, the growth in income and rents increases the cost of housing for renters. The inflation of housing costs for renters is not experienced by homeowners using a fixed-rate mortgage because their housing costs are effectively frozen at the rate of their ongoing mortgage payment. Over time, the savings accruing to homeowners can be quite substantial. Applying the same technique of discounted cashflow analysis, this savings over time can be evaluated. Since the savings grow every year, the value of the inflation premium grows as the term of ownership is extended, and this premium is not as sensitive to changes in the discount rate as is the appreciation premium.
Inflation Premium from Rental Savings
The premium accruing from the savings on rent can be substantial, but ownership periods vary, and the national average is less than 7 years; therefore, if a buyer pays this premium up front by paying more than the rental equivalent value, they may do not reach breakeven for several years. In the early years of the mortgage, the owner who paid in excess of the rental equivalent value actually falls behind the renter in terms of out-of-pocket cash outlays for housing. Over time, as the renter faces yearly increases in rents, the homeowners will eventually be paying less, and the savings will make up for the earlier period of deficit.
Inflation Premium from Rental Savings with 7 year Ownership Period
The above analysis assumes renters face the full brunt of increasing rental rates. For many apartment dwellers, this is true as landlords will raise rents every year knowing that if a renter moves out, there will be another to replace them at market rates. The circumstance is a bit different for private landlords. Most private individuals that rent out investment properties are far more concerned with the loss of cashflow resulting from the property sitting vacant than they are about maximizing income through raising rents each year. Most long-term landlords have conventional, fixed-rate financing on their properties, and because their costs are not increasing, and because they do not want to endure vacancy loss, they seldom raise rents, and when they do, they do not tend to raise them to market for fear of the tenant moving out. The result of this is that housing costs are somewhat fixed for long-term renters who rent from private individuals. These renters get to enjoy the same benefits of fixed housing costs as homeowners. The implication of this landlord behavior is that homeowners do not necessarily see the dramatic savings over renting suggested in the calculation of the inflation premium.
The investment value for home ownership is a combination of the appreciation value and the inflation value. Both accrue to the homeowners for different reasons. The appreciation value is caused by the general tendency of house prices to increase over time with the inflation of income and rents. The inflation value is a cashflow savings accruing to owners as rental rates increase while their cost of ownership is fixed. There are many variables that influence the investment value, and much depends on the assumptions behind the variables selected. Based on a typical ownership period of 7 years, and an investment environment adhering to historic norms, residential real estate has an investment value of approximately 10% the fundamental value of the property. Buyers who pay this 10% premium will see a return on their investment if they stay in the property long enough. Buyers who pay premiums in excess of this amount or who own the property for shorter timeframes do not see a return on their investment. Buyers in the Great Housing Bubble paid well in excess of the fundamental and investment value of real estate primarily due to unrealistic expectations for appreciation. If a buyer believes properties are going to appreciate at a 15% rate every year forever, paying a 100% premium over fundamental value is justified; however, since house prices cannot rise at that rate in a sustained manner, such premiums are ill advised.
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Well I hope I make more money than this in the next world.
I hope there's a lot more in it there for me.
I'd like my trousers pressed and my shoes
shined up by a rich girl,
who's only care in the world is me.
"But are these all the brains I'm entitled to have?
Don't try to make me happy, when I'm happy feeling bad.
I've got no manners or a hand you shake,
and when I won't tell the truth it's easier to fake."
So....Give, Give Give, Me More, More, More
I'd like it all.
Is the bank big enough?
coming ready or not to the next world.
I hope there's a whole lot more in it there for me.
I'd like my friends to be rich and I'll never do a stitch,
in the next world, and my only care in the world is me.
"IS THE BANK BIG ENOUGH
COMING READY OR NOT TO THE NEXT WORLD
A few notes from some of my research for you to ponder over the weekend...
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Efficient Markets Theory
The efficient markets theory is the idea that speculative asset prices always incorporate the best information about fundamental values and that prices change only because new information enters the market and investors act in an appropriate, rational manner with regards to this information(i). This idea dominated academic fields in the early 1970s. Efficient markets theory is an elegant attempt to tether asset prices to fundamentals through the common-sense notion that people would not behave in irrational ways with their money in financial markets. This theory is encapsulated by the “value investment” paradigm prevalent in much of the investment community.
Efficient Markets Theory
In an efficient market, prices are tethered to perceived fundamental valuations. If prices fall below the market’s perception of fundamental value, then buyers will enter the market and purchase the asset until prices reach their perceived value. If prices rise above the market’s perception of fundamental value, then sellers will enter the market to sell the asset at inflated prices. Efficient markets theory explains the majority of market behavior, but it has one major flaw which renders it inoperable as a forecasting tool: it does not explain those instances when prices become very volatile and detach from their fundamental valuations. This becomes painfully obvious when adherents to the theory postulate new metrics to justify fundamental valuations that later prove to be completely erroneous. The failed attempts to explain anomalies with the efficient markets theory lead to a new paradigm: behavioral finance theory.
Behavioral Finance Theory
Behavioral Finance abandoned the quest of the efficient markets theory to find a rational, mathematical model to explain fluctuations in asset prices. Instead, behavioral finance looked to psychology to explain asset valuation and why prices rise and fall. The primary representation of market behavior postulated by behavioral finance is the price-to-price feedback model: prices go up because prices have been going up, and prices go down because prices have been going down. If investors are making money because asset prices increase, other investors take note of the profits being made, and they want to capture those profits as well. They buy the asset, and prices continue to rise. The higher prices rise and the longer it goes on, the more attention is brought to the positive price changes and the more investors want to get involved. These investors are not buying because they think the asset is fairly valued, they are buying because the value is going up. They assume other rational investors must be bidding prices higher, and in their minds they “borrow” the collective expertise of the market. In reality, they are just following the herd. This herd-following has long been a valid investment technique employed by traders known as “momentum” investing(ii). It is not investing by any conventional definition because it relies completely on capturing speculative price changes. Success or failure often hinges on knowing when to sell. It is not a “buy and hold” strategy.
Behavioral Finance Theory
The efficient markets theory does explain the behavior of asset prices in a typical market, but when price change begins to feedback on itself, behavioral finance is the only theory that explains this phenomenon. There is often a precipitating factor causing the break with the normal pattern and releasing the tether from fundamental valuations. In the Great Housing Bubble, the primary precipitating factor was the lowing of interest rates. The precipitating factor simply acts as a catalyst to get prices moving. Once a directional bias is in place, then price-to-price feedback can take over. The perception of fundamental valuation is based solely on the expectation of future price increases, and the asset is always perceived to be undervalued. There are often brave and foolhardy attempts to justify these valuations and provide a rationalization for irrational behavior. Many witnessing the event assume the “smart money” must know something, and there is a widespread belief prices could not rise so much without a good reason: Herd mentality takes over.
Psychological Stages of Bubble Market
(i) Much of the history of the Efficient Markets theory is outlined in Robert Shillers paper (Shiller, From Efficient Market Theory to Behavioral Finance, 2002), “The efficient markets theory reached the height of its dominance in academic circles around the 1970s. Faith in this theory was eroded by a succession of discoveries of anomalies, many in the 1980s, and of evidence of excess volatility of returns. Finance literature in this decade and after suggests a more nuanced view of the value of the efficient markets theory, and, starting in the 1990s, a blossoming of research on behavioral finance. Some important developments in the 1990s and recently include feedback theories, models of the interaction of smart money with ordinary investors, and evidence on obstacles to smart money.”
(ii) In House Prices, Fundamentals and Bubbles (Black, Fraser, & Hoesli, 2006), the behavior of momentum investors is characterized as evidence against rationality in the marketplace. For the typical amateur speculator this is certainly true, but for momentum traders who have learned how to buy and sell to profit from the momentum, it is a rational and profitable method of speculation.
Irvinehousingblog.com is an exemplary Internet mashup. Irvine, the master-planned community in Orange County, Calif., was in many ways the epicenter of the housing boom. Many of the now-defunct ambitious subprime lenders were based there. And the O.C. housing market was a hothouse of speculation and refinancing. Today, it's the "seventh circle of real estate hell." Using realty listings, public records about debt, and YouTube videos of popular songs, an anonymous blogger who goes by IrvineRenter skewers homeowners who paid too much and are now desperately trying to recoup their investments. Realtors who post lame photos, misspell words, or engage in silly promotion-speak also come in for ridicule. At the end of each entry, the blog calculates precisely how much a homeowner—or the bank that foreclosed on his or her property—will lose if the house gets its offering price.
It is very gratifying to see nationally syndicated columnists reading and appreciating the work we do here...
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Weekend Open Thread Chart Extravaganza
Irvine, California House Price Predictions based on Historic Appreciation Rates 1984-2026
Los Angeles House Price Predictions based on S&P/Case-Shiller Indices
Orange County House Price Predictions based on Price-to-Rent Ratio 1988-2020
Irvine, California House Price Predictions based on Price-to-Income Ratio 1986-2030
One of the more interesting phenomenon observed during the bubble was the perpetuation of denial with rumors of homeowner bailouts. Many homeowners held out hope that if they could just keep current on their mortgage long enough, the government would come to their rescue in the form of a mandated bailout program. Part of this fantasy was not just that people could keep their homes, but that they could keep living their lifestyle as they did during the bubble. What few seemed to realize was any government bailout program would be designed to benefit the lenders by keeping borrowers in a perpetual state of indentured servitude. With all their money going toward debt service payments, little was going to be left over to live a life.
All of these plans had benefits and drawbacks. One of the first problems was to clearly define who should be “bailed out.” The thought of bailing out speculators was not palatable to anyone except perhaps the speculators themselves, but with regular families behaving like speculators, separating the wheat from the chaff was not an easy task. If a family exaggerated their income to obtain more house than they could afford in hopes of capturing appreciation, did they deserve a bailout? The credit crisis that popped the Great Housing Bubble was one of solvency, and there was no way to effectively restructure payments when a borrower could not afford to pay the interest on the debt, and this was a very common circumstance. None of the bailout programs did much for those with stated-income (liar) loans, negative amortization loans, and others who are unable to make the payments, and since this was a significant portion of the housing inventory, none of these plans had any real hope of stopping the fall of prices in the housing market.
The main problem with all of the plans is the moral hazard they created because those who did not participate in the bubble and behaved in a prudent manner would be penalized at the expense of those who were careless with risk. In one form or another either through free market impacts or direct subsidies from the government paid by tax dollars, these bailout plans all asked the cautious to support the reckless.The moral hazard involved and the moral outrage from those being asked to pay the bills prevented any of these plans from being implemented.
Many of the bailout plans called for changing the terms of the mortgage note. This might have been easy in the days when banks held mortgages in their own portfolios, but it was nearly impossible once these mortgages were bundled together in collateralized debt obligations and sold to parties all over the world. Even if it would have been possible to easily change the terms, the resulting turmoil in the secondary mortgage market would have caused higher mortgage interest rates. When an investor faces the risk of the government changing the terms of their contract, and these changes would not be in their favor, the investor would demand higher returns. Higher investor returns means higher mortgage interest rates which would raise the cost of borrowing. This was the opposite of what the government bail plans were trying to accomplish.
Hope Now?
The first of the numerous bailout programs was “Hope Now” introduced in October of 2007. As the name suggests, Hope Now was sold to the general public as a reason for them to hang on and continue making crushing payments for as long as possible. It was a false hope, but even false hope gave homedebtors a little emotional relief, and it provided a few more payments to the lenders. According to their website, “HOPE NOW is a cooperative effort between counselors, investors, and lenders to maximize outreach efforts to homeowners in distress.” The plan was to streamline the process of negotiating workouts between lenders and borrowers to keep borrowers making payments and ostensibly to stop them from losing their homes. The emphasis was on making payments and maximizing investor value in collateralized debt obligations. Very few people benefited from the program, despite government claims to the contrary, and no rights or benefits were conferred to borrowers that they did not already contractually have. There was much fanfare when it was first announced, but the program did far too little to have any impact on the housing market.
The next bailout was aimed directly at the lenders with the Super SIV program introduced in November of 2007. An SIV is a special investment vehicle is an off-balance-sheet investment designed to hold investments a company (usually a lender) does not want to show on their own balance sheets. It is a smoke-and-mirrors device used primarily to get around regulations intended to stop lenders from taking excessive risk. The Super SIV program was intended to purchase assets from the troubled SIVs and provide liquidity for lenders who desperately needed it. The problem with the Super SIV was simple: nobody wanted these assets. Moving bad mortgage paper around was akin to rearranging the deck chairs on the Titanic. Few in the general public knew what this program was for, and even fewer cared. Most wanted to know their government was doing something to solve the problem, and the Super SIV announcement provided them with much wanted denial.
In December of 2007, the government offered a more direct homeowner bailout plan. The proposal was to freeze the interest rates on certain loans for certain borrowers for five years. This was greeted as a panacea by all parties, and the beast of homeowner denial was fed once again. As with the Hope Now program, few people qualified, and it did nothing to hold back the tide of increasing defaults and foreclosures. The denial was short lived, and this unnamed bailout plan quickly fell from the headlines.
In the Savings and Loan disaster of the late 1980s, the government was liable to investors for their losses through the Federal Savings and Loan Insurance Corporation (FSLIC.) The government had no choice by to compel taxpayers to cover the costs of the industry bailout. The Great Housing Bubble had no such government liability. However, in February of 2008 Congress and the President signed the Economic Stimulus Act of 2008temporarily increasing the conforming loan limit for Fannie Mae and Freddie Mac, the government sponsored entities (GSEs) that maintain the secondary mortgage market. This had the ominous prospect of putting the government in a position where they may step in with taxpayer money to bail out the GSEs, even though the GSEs are explicitly not backed by the assurance of government assistance. The GSEs provide insurance to mortgage backed securities, and by raising the conforming limit, the GSEs were able to insure large, so called “jumbo” loans. This enabled the holders of jumbo loans who were unable to sell these mortgages access to capital in the secondary market. The secondary mortgage market behaves as if the GSEs are government backed, and if they were to fail due to losses from the insurance they provide, the government may have had to step in to back them. All of this was seen as another reason for homeowners in severely inflated bubble markets to hope the government was going to rescue the housing market.
Forgiveness of Debt
Perhaps the most outrageous suggestion put forth was the suggestion by the FED Chairman Ben Bernanke when he proposed lenders forgive mortgage debt in early 2008. The moral hazards were obvious. Would people stop making their payments to make sure they qualified? Would more people buy homes they could not afford then appeal for debt relief? Rational people became frightened when they heard the head banker in the United States propose massive debt forgiveness as they realized this meant the entire banking system was in peril. The implications of this proposal were lost on the typical homedebtor who only saw how they might benefit from it. Debt forgiveness was the ultimate fantasy of every homedebtor. They could be relieved of their financial burdens and get to keep their houses and their lifestyles. It did not matter to the financially troubled that the proposal made no sense and had no possibility of happening, the thought of it would motivate them to hang on a little longer to see if maybe they could hit the jackpot.
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Do Nothing
It is difficult not to become cynical about all the various bailout programs, and the proposals outlined were not the only ones discussed in the public forum. There was a steady drumbeat of public plans and announcements that were never substantial, and their only purpose seemed to be to foster denial among those who needed it.
At the time of this writing, no substantive bailout program has been implemented, and that is a good thing. There is no possible bailout program without the commensurate moral hazards and unfair benefits they would contain. The best course of action would be to ease the transition of people from overextended homeowner to renter and not to attempt to manipulate the financial markets for the benefit of a few. There is nothing that can be done to prevent of the collapse of a financial bubble. The solution lies in easing the pain of their deflation and in preventing them from inflating in the future.
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Rescue me, oh take me in your arms
Rescue me, I want your tender charm
'Cause I'm lonely and I'm blue
I need you and your love too, come on and rescue me
Come on, baby, and rescue me
Come on, baby, and rescue me
'Cause I need you by my side Can't you see that I'm lonely
A couple of weeks ago, I wrote a two part analysis post on Structured Finance and the CDO market. There was one item of import that needed clarification, so I thought I would take this weekends open thread to do it.
I hope you are all enjoying the free preview of my rough draft for The Great Housing Bubble (or whatever the publisher may want to call it.) Vetting this rough draft in the open forum of this blog has been invaluable to me. The thousands of fact-checkers who read the blog each day have forged its message. I can't thank you all enough. The daily inundation of analysis posts will end soon as I am getting close to completion of the draft manuscript, so we will be getting back to our daily dosage of schadenfreude soon enough.
Mortgage Default Losses
There is risk of loss in any investment, and losses in collateralized debt obligations arise from the difference in the book value of the underlying mortgage note and the actual resale value of the collateral on the open market, if this collateral is subject to foreclosure. There is an important distinction that must be made between the default rate on a mortgage loan and the resultant loss incurred when a default occurs. High mortgage default rates do not necessarily translate into high mortgage default losses and vice-versa.
Subprime loans have had high default rates since their introduction. When subprime mortgages began to capture broader market share starting in 1994, the rate of home ownership in the United States began to rise. The increasing use of subprime loans and the subsequent increase in home ownership rates put upward pressures on house prices. As house prices began their upward march, the default losses from subprime defaults began to fall because the collateral was obtaining more resale value. This made subprime lending, and its associated high default rates, look less risky to investors because these default rates were not translating into default losses. As time went on and prices continued to rise, subprime lending established a track record of investor safety which drew more capital into the industry; however, since the relative safety of subprime lending was entirely predicated upon rising prices, it was an industry doomed to fail once prices stopped rising.
Take this phenomenon to its extreme and its instability becomes readily apparent. Imagine a time when prices are rising, perhaps even due to the buying of subprime borrowers, and imagine what would happen if 100% of the subprime borrowers defaulted without making a single payment. It would take approximately one year for the foreclosure and relisting process to move forward, and during that year, the prices of resale houses would have increased. When the lender would go to the open market to sell the property, they would obtain enough money to pay back the loan and the lost interest so there would be no default loss. What just happened? Lenders became de facto real estate speculators profiting from the buying and selling of homes in the secondary market rather than lenders profiting from making loans and collecting interest payments. This profiting from speculation is the core mechanism that disguised the riskiness of subprime lending. When these speculative profits evaporated when prices began declining, the subprime industry imploded and its implosion exacerbated the decline of home prices.
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There are no lyrics, but I am a long-time fan of Native American flute Music. Carlos Nakai is awesome.
During the Great Housing Bubble, many speculators tried to make money through trading houses. The vast majority of these traders were not professionals but amateurs who thought they could be professionals. Most amateurs ended up losing money because they did not understand what it takes to be successful in a speculative market. The first and most obvious difference in the investment strategy between professional traders and the amateurs in the general public is their holding time. Traders buy with intention to sell for a profit at a later date. Traders know why they are entering a trade, and they have a well thought out plan for their exit. The general public adopts a “buy and hold” mentality where assets are accumulated with a supposed eye to the long term. Everyone wants to be the next Warren Buffet. In reality this buy-and-hold strategy is often a “buy and hope” strategy — a greed-induced, emotional purchase without proper analysis or any exit strategy. Since they have no exit strategy, and since they are ruled by their emotions, they will end up selling only when the pain of loss compels them. In short, it is an investment method guaranteed to be a disaster.
There is plenty of evidence houses were used as a speculative commodity during the Great Housing Bubble. Since the cost of ownership greatly exceeded the cashflow from the property if used as a rental, the property was not purchased for positive cashflow, and by definition, it was a speculative purchase. Confirming evidence for speculative activity comes from the unusual and significant increase in vacant houses in the residential real estate market.
National Homeowner Vacancy Rate, 1986-2007
If markets had not been gripped by speculative fervor, vacancy rates would not have risen so far above historic norms. If houses had been purchased for investment purposes to make money from rental income, the houses would have been occupied after purchase and vacancy rates would not have gone up. A rise in vacancy rates would have resulted in downward pressure on rents, and the investment opportunity – if it had existed initially (which it did not) – would have disappeared with the declining rent. There is only one reasonable explanation for increasing house prices and increasing rents during a period when house vacancy rates increased 64%: people were purchasing houses for speculative gains and leaving them unoccupied while the owners waited for prices to rise.
When house prices stopped their dizzying ascent, many speculators found themselves with large monthly debt service costs and no income to offset expenses. Many chose to quit paying their mortgage obligations and allowed the property to be auctioned at foreclosure. Many chose to rent the properties to reduce their monthly cashflow drain, and they became accidental landlords. In the vernacular of the time, they became floplords – flippers turned landlords.
Becoming a floplord was fraught with problems. First, they were not covering their monthly expenses, so the losses on the ”investment” continued to mount. This was a convenient form of denial for losing speculators because they believed they were buying themselves time until prices rose again allowing them to sell later either at breakeven or for a profit. Since they bought in a speculative mania, prices were not going to recover quickly and the denial soon evolved into fear, anger and finally acceptance of their fate.
Another problem floplords faced was their own inexperience at managing rental properties. Most had never owned or managed a rental property, and none of them purchased the property with this contingency in mind. They often found poor tenants who did not reliably pay the rent or properly care for the property. This created even more financial distress and greater loss of property value as the property deteriorate through misuse.
The problems of renting were not confined to the floplords. Sometimes the renters were the ones who suffered. Many floplords collected large security deposits and monthly rent checks from tenants and failed to pay their mortgage obligations. This situation is called “rent skimming,” and it is illegal in most jurisdictions, but this crime is seldom prosecuted. Most of the time, the first indication a renter had that their rent was being skimmed was finding a foreclosure notice on their front door. By the time of notification, several months of rental payments were gone and the renters were evicted soon after the foreclosure. Renters seldom recovered their security deposits.
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Valuations in Northwood for homes 2,000+ SF are still bubbly. Recently we featured a floplord looking to cover about 2/3 of his ownership cost (or ask 50% more than the property is worth depending on your point of view.) Today's post features another floplord in the neighborhood with Secret Gold. The property is going to be a big loser for the owner, and since you can rent an identical property for $3,900, it doesn't make much sense to spend around $5,500 a month to buy it, unless of course, you like the $7,400 a month equity burn on top of your oversized payment.
WOW!! Take a look at this Beautiful home in Desirable gated commmunity of Northwood II. OUTSTANDING SCHOOLS, PARKS, POOL AND CLUB HOUSE. ! Beautiful quality upgrades. Gorgeous gourment kitchen with cherry cabinerty, stainless appliances includes, wine refrigerator. Island breakfast bar, beautiful granite counters. Prestine wood floors, upgraded carpet, window coverings. French doors lead to relaxing patio with soothing waterfall. Short distance to shopping, library and the NEW GREAT PARK IN PROGRESS. Move-in condition. Low homeowner association fee.
WOW!! This realtor can't spell commmunity, gourment, cabinerty, or Prestine. I am not a stickler about spelling, and in fact, I am not a great speller, but when the computer puts a big red line underneath it, I have to go out of my way to ignore it. Please, someone at the MLS needs to get spell check software.
What does the Great Park have to do with anything?
Interesting that $120 a month for an HOA fee is considered low.
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This property was purchased at the peak, and now if they get their asking price, the sellers stand to lose $245,280 after a 6% commission. This is their best-case scenario. If they become a floplord and hold the property all the way to the bottom, they will lose close to $500,000. Of course, they could always hold it until prices come back... in 2030.
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Let your arms enfold us
Through the dark of night
Will your angels hold us
Till we see the light
Hush, lay down your troubled mind
The day has vanished and left us behind
And the wind, whispering soft lullabies
Will soothe, so close your weary eyes
Let your arms enfold us
Through the dark of night
Will your angels hold us
Till we see the light
Sleep, angels will watch over you
And soon beautiful dreams will come true
Can you feel spirits embracing your soul
So dream while secrets of darkness unfold
Commodities are items of value and uniform quality produced in large quantities and sold in an open market. Although every residential real estate property is unique, these properties became uniformly desired by investors because all real estate prices rose during the Great Housing Bubble. The commoditization of real estate and the active, open-market trading it inspires caused houses to lose their identity as places to live and call home. Houses became tradable stucco boxes similar to baseball playing cards where buying and selling had nothing to do with possession and use and everything to do with making money in the transaction.
In a commodities or securities market, rallies unsupported by valuation measures will fall back to fundamental values. It is very clear the rally in house prices was not caused by a rally in the fundamental valuation measures of rent or income. Many people forgot the primary purpose of a house is to provide shelter — something which can be obtained without ownership by renting. Ownership ceased to be about providing shelter and instead became a way to access one of the world’s largest and most highly leveraged commodity markets: residential real estate.
Commodities markets are notoriously volatile. In fact, this volatility is the primary draw of commodities trading. If market prices did not move significantly, traders would not be interested in the market, and liquidity would not be present. Without this liquidity, hedgers could not sell futures contracts and transfer their risk to other parties, and the whole market would cease to function. Commodities markets exist to transfer risk from a party that does not want it to a party who is willing to assume this risk for the potential to profit from it. The commodities exchange controls the volatility of the market through the regulation of leverage. It is the exchange that sets the amount of a particular commodity that is controlled by a futures contract. They can raise or lower the amount of leverage to create a degree of volatility attractive to traders. If they create too much leverage, trader’s accounts can be wiped out by small market price movements. If they create too little leverage, traders lose interest.
The same principles of leverage that govern commodities markets also work to influence the behavior of speculators in residential real estate markets. If leverage is very low (large downpayments or low CLTV limits,) then speculators have to use large amounts of their own money to capture what become relatively small price movements. If leverage is very high (small downpayments or high CLTV limits,) then speculators do not have to put up much money to capture what become relatively large price movements. The more leverage (debt) that can be applied to residential real estate, the greater the degree of speculative activity that market will see. Also, the smaller the amount of money required to speculate in a given market, the more people will be able to do so because more people will have the funds necessary to participate. When lenders began to offer 100% financing, it was an open invitation to rampant speculation. This makes the return on investment infinite because no investment is required by the speculator, and it eliminates all barriers to entry to the speculative market. In a regulated commodities market, the trader is responsible for all losses in their account. In a mortgage market dominated by non-recourse purchase money mortgages, lenders end up assuming liability for losses in the speculative residential real estate market. This is a fantastic deal for speculators; for the lenders... not so much.
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Today's featured property is a classic example of speculation in the residential real estate market. When this seller was a buyer, they utilized 100% financing right at the peak of the bubble. Now that resale values have gone south, the speculator is letting the property go into foreclosure, and the lender is going to be left holding the bag.
Terrific Location in Irvine--conveniently close to parks, schools, shopping, dining and entertainment. Beautiful landscape/hardscape done by professionals in the backyard. Hardwood floors throughout first floor.
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If the lender gets the asking price on this one, they stand to lose $192,500 after a 6% commission. This also assumes the borower is current on the mortgage and there is not a large amount of deferred payments adding to the balance due. All part of the price these lenders paid for enabling people to trade houses as commodities and assuming the risk of loss.
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God money Ill do anything for you.
God money just tell me what you want me to.
God money nail me up against the wall.
God money dont want everything he wants it all.
Head like a hole.
Black as your soul.
Id rather die than give you control.
Head like a hole.
Black as your soul.
Id rather die than give you control.
Bow down before the one you serve.
Youre going to get what you deserve.
Bow down before the one you serve.
Youre going to get what you deserve.
God moneys not looking for the cure.
God moneys not concerned with the sick among the pure.
God money lets go dancing on the backs of the bruised.
God moneys not one to choose
No you cant take it
No you cant take it
No you cant take that away from me
Mortgage Equity Withdrawal or MEW is the process of obtaining cash through refinancing residential real estate using the accumulated equity as collateral for the loan. Before MEW, a homeowner would have to wait until the property was sold to get their equity converted to cash. Apparently, this was deemed an inefficient use of capital, so lenders found ways to “liberate” this equity with home equity lines of credit or cash-out mortgage refinancing. The impact of MEW on equity is obvious; it reduces it by increasing the loan balance. It has been noted that equity is a fantasy and debt is real, and MEW is the process of living the fantasy with the addition of very real debt. MEW has been utilized by homeowners for home improvement for decades, but the widespread use of this money for consumer spending was an innovation of The Great Housing Bubble. Since consumer spending is almost 70% of the US economy, mortgage equity withdrawal was the primary mechanism of economic growth after the recession of 2001 – a recession caused by the deflation of another asset bubble, the NASDAQ technology stock bubble.
Many people who extracted their home equity lost their homes for lack of ability to refinance or make their new payments. After so many people lost their homes due to their own reckless borrowing, it is natural to wonder why these people did it. Why did they risk their home for a little spending money? First, it was not just a little money. Many markets saw home values increase at a rate equal to the median income. It was as if their home was another breadwinner. The lure of this easy money was too much for many to resist. Also, during the bubble rally people really believed their house values would go up forever, and they would always have the ability to refinance enormous debts at low interest rates and maintain very low debt service costs. Most people did not think it possible they would end up in circumstances where they would lose their homes; however, they did lose their homes; they were wrong, very wrong. Given these beliefs, the equity accumulating in their house was “free money” they just needed to access in order to live and to spend like rich people. Even though they were consuming their net worth, and making themselves poor, they believed they were rich, and they needed to spend accordingly.
Mortgage Equity Withdrawal 1991-2007
Most homeowners do not save money for major improvements and required maintenance, and these homeowners often take out home equity lines of credit as a method of mortgage equity withdrawal to fund home improvement projects. The logic here is that renovations improve the property so an increase in property value offsets the additional debt. In reality, home improvement project rarely adds value on a dollar-for-dollar basis, particularly with exterior enhancements which often only return 50 cents on the dollar in value. The home-improvement craze was so common that the term pergraniteel was coined to describe the Pergo fake wood floors, granite countertops, and steel appliances that were popular at the time.
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Much of the money homeowners borrowed fueled consumer spending and reinforced poor financial management techniques. It was common during the bubble rally for people to run up enormous credit card bills then refinance every year and pay them off. It is foolish enough to finance consumer spending, but it is even more foolish to pay for this spending over the 30-year term of a typical mortgage. The consumptive value fades quickly, but the debt endures for a very long time. Many people responded to the “free money” their house was earning by liberating their equity as soon as they could so they could buy cars, take vacations, and generally live the good life. This borrow and spend mentality was actually encouraged by lenders who were eager to make these loans and even the government who was benefiting by economic expansion and higher tax receipts.
Gross Domestic Product with and without the effect of Mortgage Equity Withdrawal
The recession of 2001 was caused by the collapse of stock prices and the resulting diminishment of corporate investment. The recession was shallow, but the economy had difficulty recovering mostly due to continued erosion of manufacturing jobs. The Federal Reserve under Alan Greenspan was desperate reignite economic growth, so the FED funds rate was lowered to 1% and kept there for more than a year. It was hoped this increased liquidity would go into business investment to restart the troubled economy; instead, it went into mortgage loans and consumer’s pockets through mortgage equity withdrawal. Basically, the entire recovery from 2001 through 2005 was an illusion creating by excessive borrowing and rampant spending by homeowners. The economy did not grow through production, it grew through consumption.
There are many theories as to the decline and fall of the Roman Empire. One of the more intriguing is the idea that Rome fell because it was weakened by the parasitic nature of Rome itself. Rome existed to consume the resources of the empire. Boats would come to the city loaded with goods and leave the city empty. Consumption kept the masses happy and thereby quelled civil unrest. The Roman Empire was the world’s only superpower with an unsurpassed military might. Equally unsurpassed was its ability to consume resources. Does any of this sound like the United States? The United States has clearly become a consumer nation, and the government does not have a problem with borrowing huge sums of money to keep the economic engine of consumption going. In early 2008, the Congress passed a “stimulus” package where many people would receive direct gifts of money to go spend and keep the economy going. Since the Federal Government was already running a deficit, this money was borrowed from future tax receipts and given to the populace to spend. With house prices crashing, direct handouts of borrowed government money were necessary to make up for the loss of borrowed private sector money that used to be available through mortgage equity withdrawal.
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The best things in life are free
But you can keep 'em for the birds and bees
Now give me money (that's what I want)
That's what I want (that's what I want)
That's what I want (that's what I want), yeah
That's what I want
Your lovin' gives me a thrill
But your lovin' don't pay my bills
Now give me money (that's what I want)
That's what I want (that's what I want)
That's what I want (that's what I want), yeah
That's what I want
Money don't get everything, it's true
What it don't get, I can't use
Now give me money (that's what I want)
That's what I want (that's what I want)
That's what I want (that's what I want), yeah
That's what I want
How common was this phenomenon of mortgage equity withdrawal? We have profiled many examples of it, and today's property is yet another. Now give me money, that's what I want...
Back on the market!!! REDUCED TO THE RIDICULOUS AND WHAT A DEAL!!!!!!!!! What an opportunity!!! Wonderful single level home with breakfast nook. Recently remodeled kitchen & bathrooms, newer carpeting and wide baseboards create a nice theme as you are warmed by the custom tuscan colors throughout in this wonderful single level. Extra LARGE living room/dining room with fireplace for those large family gatherings. Lush atrium brings the outside in. Down the street from parks and nearby schools. Turnkey!!! Preforeclosure
REDUCED TO THE RIDICULOUS AND WHAT A DEAL!!!!!!!!! It is writing with ALL CAPS and numerous exclamation points that reduces this listing to the ridiculous.
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Notice this property was purchased in 1996 for just over $200,000, and now it is a preforeclosure selling for over $600,000? How is that possible? Mortgage equity withdrawal.
In 1996, this property was originally purchased with a first mortgage of only $142,000, and the buyer put $62,000 down.
In early 2001, they opened a HELOC for $60,000 -- their first step toward the Dark Side.
In 2002, they refinanced for $227,000 pulling out all their equity at the time.
In 2003 they opened another $100,000 HELOC.
In 2004 the HELOC was $189,800.
In 2005 the HELOC was increased again to $250,000.
In 2007 the HELOC was increased to $318,000.
The sum of their debts appears to be $545,000, so unless their is more debt not recorded in the public record, there may still be some equity in this property. So why is it in foreclosure? The owners probably cannot make their payments. The credit crunch is a problem of borrower insolvency, and this borrower is likely insolvent. Maybe they will get lucky and sell this property to pay off their debts?
You can see the steady pattern of mortgage equity withdrawal that almost exactly mirrors the mortgage equity withdrawal chart.
Of course, these people are selling their home now, and the HELOC income stream is coming to an end. So what does this mean for our borrow-and-spend economy? It is likely we are going to experience a severe consumer spending recession. Borrowers like today's featured seller are being cut off from credit, and their wild spending is going to stop. Today's property owner is one of many who are facing the same circumstances. The cumulative impact of the loss of this massive spending stimulus from all these homeowners is going to be catastrophic to our economy. If the whole nation is going into a spending recession due to this phenomenon, imagine how bad it is going to be here in the conspicuous consumption capital of the world -- Orange County, California.
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Unsold in 90+ days
